Is it possible to know how much QE pumped up stocks?

Ivan Martchev is an investment specialist with institutional money manager
Navellier and Associates.
Previously, Ivan served as editorial director at
InvestorPlace Media. Ivan was
editor of Louis Rukeyser's Mutual Funds and associate editor of Personal
Finance. Ivan is also co-author of
The
Silk Road to Riches (Financial Times Press).

Last year, I had to do some work on utility stocks, and I saw a recurring picture. Most of them were yielding 20% or more below their five-year averages. Then in May 2013, Ben Bernanke flipped the taper switch, and utilities begun to underperform. In early 2014, the Fed's quantitative-easing (QE) tapering has spilled over into the broad stock market. I wonder, is it possible to quantify how much QE has boosted stock prices?

QE was a maneuver to stop the system from deleveraging. It suppressed long-term interest rates in order to get businesses to refinance debt and invest, consumers to refinance debt and buy houses, and the government to refinance debt and spend. On the point of funding the U.S. government, the Fed says this was not a goal, but an unintended consequence in order to help consumers and businesses. Still, no one can argue that borrowing at negative real interest rates (due to Fed actions) did not help Uncle Sam at a time of record fiscal deficits.

QE also boosted stock prices and lowered dividend yields across the stock market. It is easy to see why utility stocks would see their prices rise and yields fall while the Fed is suppressing long-term interest rates. The Fed was, in effect, chasing investors out of Treasurys and investment-grade bonds and into stocks. Income investors were reaching for yield in the most conservative places they can find.

The investor exodus out of bonds spilled beyond utilities. In many cases, if you looked at consumer staples or integrated energy companies with investment-grade credit rating, the stocks would yield quite a bit more than their intermediate-term bonds, so investors went for the stocks. Conoco PhillipsCOP, -1.99%
is one of my favorite energy companies, as it dramatically restructured in order to achieve higher profitability for its shareholders. Conoco has grown its dividend consistently and sold many lower-margin assets, as well as spun off its more volatile refining business as a separate company.

COP has a dividend yield of 4.3%. Conoco also has intermediate-term A-rated 6% bonds due 2020 with a yield to maturity of 2.37%. Looking at Conoco's debt structure, to get to a bond issue that yields anything close to its dividend yield you have to go with a bond maturity all the way up to 2038. Those long-dated bonds have a yield to maturity of 4.27% with a 5.9% coupon. But they also have significant duration risk. It is easy to see how COP shares look appealing to an income investor, rather than its longer-duration bonds.

My point is that the premium that was assigned to Treasurys and investment grade bonds due to QE has also been assigned to stocks. The QE valuation premium for stocks is more extreme with interest-rate sensitive stocks, but it also exists for the broader stock market. Naturally, as QE is being (mini) tapered, one would expect that premium to normalize and get priced out of the stock market. The question then becomes how big is the QE premium in stocks that is about to disappear. When the Fed is tapering QE, it is also removing the valuation premium QE placed on the stock market.

In 2013 (and not all fourth-quarter EPS have been reported) the S&P 500 had earnings growth of 4.9%, but the index was up 30%. If earnings grew slower than the index, its PE multiple was expanding.

The current 12-month forward P/E ratio is 14.7. The P/E ratio of 14.7 for the index as a whole is above the five-year average forward 12-month P/E ratio of 13.1, and above the 10-year average forward 12-month P/E ratio of 13.9. The forward P/E got as high as 15.2 at the recent highs.

The S&P 500 forward P/E ratios have also been as low as 10.8 in 2011. It is quite the valuation expansion to see the average stock multiple go up 30%. (The trailing S&P 500 P/E chart shows a similar trend.) I know that people may say that at a P/E of 10.8 the stock market was depressed and now it is normalizing, but looking from a longer-term perspective, valuations seems to be stretched.

A longer-term version of the P/E ratio that takes cyclical extremes into perspective is the Cyclically Adjusted P/E Ratio, or CAPE Ratio, also known as the Shiller P/E. This P/E is based on average inflation-adjusted earnings from the previous 10 years. Such a long-term average takes into perspective the true earnings power of companies in the S&P 500 index and stands at present at 25.36.

Before the tech bubble, 25.36 was considered an extreme valuation for stocks. If we assume that QE would end in 2014 and the Fed will no longer be chasing investors out of bonds, it will be reasonable to expect that valuations would normalize. The CAPE PE has been as low as 4.78 in 1920 and as high as 44.2 in 1999. The average of all CAPE P/E data 16.51.The consensus projected EPS growth for the S&P 500 stands at 9.6% at last count. (Here is a link to Dr. Shiller's data.)

It seems to me that the valuation of the stock market is quite a bit away from its long-term average for us not to be looking for a further valuation compression based upon Fed's QE exit.

Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own. Navellier and Associates does not hold positions in any securities mentioned for its clients. This is neither a recommendation to buy nor sell the securities mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities

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